The Market Still Isn't Giving Itochu Full Credit For Its Self-Improvement

Japanese trading company Itochu (OTCPK:ITOCY) has a tough act to follow - its own meaningful improvement over the past five years. The company was more willing than most of its Japanese trading peers to deemphasize commodity/resource businesses, and it moved fairly quickly here, building up non-resource businesses like its food, “machinery”, and finance operations. Those moves have led to better ROE and cash flow margin performance versus its peers, and Itochu shares have done well relative to peers like Mitsui (OTCPK:MITSY), Mitsubishi (OTCPK:MSBHY), Marubeni (OTCPK:MARUY), and Sumitomo (OTCPK:SSUMY) over that time.

Itochu’s execution has not been flawless, though, and investors are right to worry about the risk of another sizable poor investment (like CITIC (OTCPK:CTPCY)), not to mention the risk of lower long-term returns as Itochu has de-risked its business. I believe its underlying business mix, and the investment priorities that have been demonstrated over the last couple of years, argue for a higher price today, but the upcoming announcement of the company’s next three-year plan could be a significant share mover.

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The Market Still Isn't Giving Itochu Full Credit For Its Self-Improvement

Seeking Alpha: Itochu Management's Unrealistic Goals Look Like A Real Obstacle

For some time now I had been thinking that Itochu (OTCPK:ITOCY) was a good value play on sector (Japanese trading companies) that is often overlooked as hopelessly unwieldy and uncommitted to shareholder value creation. In particular, I liked Itochu for its relatively lower exposure to natural resources (at least compared to Mitsui, Marubeni, and Mitsubishi) and its determination to pursue leadership positions in textiles, manufacturing, retailing, and food, with a particular focus on China.

This looks like I case where I should have gone with the conventional wisdom. While Itochu is indeed one of the most China-leveraged Japanese trading companies, I am concerned about the declines in earnings quality, management's strategic investment decisions, and their apparently unrealistic views concerning many aspects of the business. While the local shares have been quite strong over the past year (up more than 30%; while currency has reduced the gains to ADR shareholders to below 10%), and there is upside if Itochu can consistently deliver double-digit ROEs, I think it is time to call it a day with a company where I just can't share management's views on the best path forward.

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Itochu Management's Unrealistic Goals Look Like A Real Obstacle

Seeking Alpha: Itochu May Pause, But Has A Good Long-Term Model

Japan's third-largest trading company, Itochu (OTCPK:ITOCY), has not done that well since I last wrote about the company. A 1% gain in the Tokyo-listed shares and a 4% gain in the ADRs is better than the performance of the Nikkei 225 (down about 6%), but not at all impressive relative to the other trading companies (Mitsui (OTCPK:MITSY) has done much better, Sumitomo (OTCPK:SSUMY) and Mitsubishi (OTCPK:MSBHY) a little better, and Marubeni (OTCPK:MARUY) worse). Some of this could be driven by a slower move toward share repurchases or steeper-than-average expected decline in FY 2015 ROE, with Itochu's rivals closing a bit of the gap in terms of returns on equity and capital.

Capital may be chasing those self-improvement stories, but I think Itochu is still the better play for the long term. Management has deliberately moved away from more volatile resource businesses and is looking for its focus on consumer-related products to generate above-average returns for the long-term. These giant unwieldy conglomerates are not going to suit every investor, but Itochu still looks undervalued below $29 to $32 per ADR.

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Itochu May Pause, But Has A Good Long-Term Model

Seeking Alpha: The Market Doubts Itochu Will Continue To Outpace Its Rivals

Sell-side analysts can be a stubborn lot. Even when a less-favored company outperforms, it's not uncommon to see follow-up reports declaring that its outperformance can't continue. When looking at the large Japanese trading companies, Itochu's (OTCPK:ITOCY) outperformance certainly stands out - the shares are up more than 50% in Japan while rivals Mitsui (OTCPK:MITSY), Marubeni (OTCPK:MARUY), Sumitomo (OTCPK:SSUMY), and Mitsubishi (MSHBY) are up around 20% to 30%.

Itochu's strong performance doesn't strike me as a fluke. Management has consciously and deliberately sought to create a balanced collection of assets, with operations in food and machinery offsetting the volatility to the commodities operations. With management looking to build its non-resource operations at a 2-to-1 ratio with the resource operations, I believe this will continue to benefit the company's stability and full-cycle returns without overly curtailing the company's upside to higher commodity prices. Investors must note the significant impact of currency on these shares (8001.T shares are up 55% over the past year, while ITOCY is up about 22%), but I believe Itochu's superior returns, shareholder-focused management, and balanced business could merit another 15% to 20% in gains from here.

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The Market Doubts Itochu Will Continue To Outpace Its Rivals

Investopedia: Itochu - It's Not Easy, But It Might Be A Good Value

If you're a quant investor who loves to go through a business line by line, trading companies like Itochu (OTC:ITOCY) will either be a dream come true or a living nightmare. Like most trading companies, Itochu operates over 130 branches in over 60 countries, with about 700 subsidiaries and affiliates ... and it's not even the largest of the Japanese trading companies (trailing the likes of Mitsui (OTC:MITSY) and Sumitomo (OTC:SSUMY)).

While these large, far-flung enterprises are generally derided as hulking behemoths (and there's an element of truth to that), I wouldn't sleep on Itochu. The company has not only made a concerted effort to trim away underperforming assets, the company has also devoted increasing efforts and assets to building up its non-resource businesses, particularly those aimed at the Chinese consumer.

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Investopedia: 2011 In Review - Conglomerates

Conglomerates, virtually by definition, are an unwieldy and heterogeneous lot. Many have their fingers in multiple industry groups, but not necessarily in the same or overlapping categories. Consequently, it's rare to find sector funds or sector performance statistics that have any particular utility. That said, a look at a select list of top conglomerates shows that this was a pretty challenging year for the sector.


Only A Few Winners 
Admittedly there's some selection bias here, as there is no standard definition of a "conglomerate" and many would-be conglomerates are folded into other industrial or financial categories. Nevertheless, it looks like the winners in the conglomerate space were few and far between.


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http://stocks.investopedia.com/stock-analysis/2011/2011-In-Review---Conglomerates-TYC-BRK-A-HIT-PHG1222.aspx